When Gold Really Starts To Glitter

Gold really starts to glitter when you can't get an "honest" return on your
money market investments in any major currency. That is, when the inflation
rate is above money market rates in all major currencies, investors turn to
gold as a store of value. Looking at the dollar and the euro, currently, you can get
an honest return on your money. In May, the year-over-year percent change in
the all-items U.S. CPI was 2.8%. The fed funds rate target was 3.00%. Thus,
the inflation-adjusted fed funds rate was positive by 20 basis points - the
first positive "real" fed funds rate since September 2002. With May year-over-year
eurozone CPI inflation at 1.9% and European Central Bank's (ECB) minimum-bid
repo rate (the equivalent of the fed funds rate) at 2.00%, the "real" ECB rate
was positive by 10 basis points. Although both the Fed's and the ECB's policy
rates were in positive territory in May vs. their respective inflation rates
and only 10 basis points apart from each other, their paths toward near parity
have been different, as can be seen in Chart 1. The real fed funds rate has
spent more time in recent years below zero than has the real ECB rate. With
the ECB having held its policy rate steady at 2.00% since March 2003, there
has been a slow descent in the real ECB rate as eurozone inflation has picked
up. After reaching a recent low in May 2004, the real fed funds rate has been
battling its way back into positive territory through a combination of moderating
inflation and a rising nominal fed funds rate target.

With eurozone economic growth faltering, the ECB is under increasing pressure
to cut its policy rate. It is doubtful that eurozone consumer inflation would
decline by as many basis points as the interest rate cut. Thus, if the ECB
were to lower rates in the near term, it is likely that the real ECB rate could
turn negative again. It would be a hyperbole to say that the Fed is under increasing
pressure to pause in its interest rate increases. But leading indicators, especially
the flatter yield curve and the slowdown in real money supply growth are sending
a strong signal that a soft landing is at hand for the U.S. economy. And if
the Fed continues much longer on it course of interest rate hikes, it runs
the risk of bursting the housing bubble and plunging the U.S. economy into
a recession. So, although there is not overt pressure on the Fed to call a
cease fire in its rate hikes, there is a growing expectation that it might
be near the end of Phase 1, at least, of this tightening cycle. At the same
time, with energy prices flaring up again, all-items CPI inflation might start
to climb again.

I wonder if the gold market is beginning to reflect the expectation that an
honest return on one's money may be hard to come by in the not-too-distant
future. Let's take a look at the behavior of gold prices in U.S. dollar terms
and euro terms in recent years and weeks. Chart 2 shows these gold prices on
a monthly basis from January 2001 through May 2005. During that period, the
dollar price of gold rose by a net 51.1%. In contrast, the euro price of gold
rose by only a net 13.6%. You will recall that from 2002 through 2004, the
dollar was depreciating against the euro. That would put bias upward the dollar
price of gold.

Chart 2

Chart 3 shows the dollar and euro prices of gold on a daily basis. These prices
are moving in closer tandem than they have in recent years. So far in June
of this year, both the dollar and euro prices of gold have been rising. From
May 31 through today, June 23 (Chart 3 goes up only through June 22), the dollar
price of gold has risen by 6.5% while the euro price has risen by 9.3%. The
larger percentage increase in the euro price of gold is related to the depreciation
of the euro vs. the dollar. But the important take away is that the price of
gold is rising significantly in both dollar and euro terms. As I said
at the outset, gold really begins to glitter when investors cannot get an honest
return on their money. I think those investor suspicions are beginning to set
in.

Paul L. Kasriel
Director of Economic ResearchThe Northern Trust CompanyEconomic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul joined the economic research unit of The Northern Trust Company in 1986
as Vice President and Economist, being named Senior Vice President and Director
of Economic Research in 2000. His economic and interest rate forecasts are
used both internally and by clients. The accuracy of the Economic Research
Department's forecasts has consistently been highly-ranked in the Blue Chip
survey of about 50 forecasters over the years. To that point, Paul received
the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic
forecast among the Blue Chip survey participants for the years 2002 through
2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five
of The Wall Street Journal survey panel of economists. In January 2009, The
Wall Street Journal and Forbes cited Paul as one of the few who identified
early on the formation of the housing bubble and foresaw the economic and financial
market havoc that would ensue after the bubble inevitably burst. Through written
commentaries containing his straightforward and often nonconsensus analysis
of economic and financial market issues, Paul has developed a loyal following
in the financial community. The Northern's economic website was listed as one
of the top ten most interesting by The Wall Street Journal. Paul is the co-author
of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank
of Chicago. He has taught courses in finance at the DePaul University Kellstadt
Graduate School of Business and at the Northwestern University Kellogg Graduate
School of Management. Paul serves on the Economic Advisory Committee of the
American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily
represent the views of The Northern Trust Company. The information herein is
based on sources which The Northern Trust Company believes to be reliable,
but we cannot warrant its accuracy or completeness. Such information is subject
to change and is not intended to influence your investment decisions.